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Contrarian, growth at reasonable price, management change, cannabis stocks
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Editors' Note: This article covers stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

2014 started off with a surge in stocks tied to cannabis. As I detailed last week, volumes and prices soared as new investors poured into the market, induced apparently by a media frenzy over the implementation of Colorado's new legal cannabis program on January 1st. While prices got ahead of themselves, the recent sharp correction has created more reasonable entries in many stocks. My read is that investors should get used to volatility in the sector and anticipate a series of similar surges as the year progresses, with the Washington state legal cannabis implementation, which will likely be in June, the November elections and perhaps some additional unanticipated events serving as key catalysts.

The proverbial genie is out of the bottle. The bull case for the sector is clear and compelling. Quite simply, a triple-win for society is in its early stages: Consumers and patients will get what they want or need at higher levels of quality and lower prices, governmental entities will get much needed tax revenues and cost savings from eliminating wasteful law enforcement and incarceration expenses, and entrepreneurs will create tremendous wealth for themselves and their investors.

I am not here today to plead the bullish case in detail, but I have embraced it after months of study, including conversations with industry leaders, private investors and public-company executives. The early 2013 bubble in the publicly-traded cannabis stocks attracted my attention, and, after careful study, I was able to confidently launch in September an internet-based community of investors focused on "capitalizing on cannabis." For those who would like get a better understanding of the many changes that lie ahead, I suggest reading Arcview's "The State of Legal Marijuana Markets 2nd Edition" that will be delivered this month (free excecutive summary).

For investors who want to embrace the bullish industry outlook by investing in public companies, it is unfortunate that the choices are restricted almost entirely to "penny stocks", with the exception of GW Pharma (NASDAQ:GWPH), which trades on the NASDAQ but, as a biotech, offers its own set of risks. The industry is highly fragmented, and the revenues of the publicly-traded companies represent a tiny fraction of the legal and medical cannabis markets at present. The bottom-line is that picking winners isn't so easy - many of those most likely to succeed aren't publicly traded yet. A good analogy might be Google, which was founded in 1998 but didn't trade publicly until its 2004 IPO.

A limited supply of stocks and very strong demand creates a big challenge for investors in the sector. Based on my observations, many of those embracing the theme of cannabis investing are new to investing, often choosing stocks on parameters like the ticker or the name of the company rather than doing even basic due diligence. With this in mind, I wanted to share some basic steps investors can take before diving in blindly.

Business Model

The 20 or so companies with market caps in excess of $10mm that I have studied have a wide range of business models. Investors should try to understand the plan of the company and evaluate if it makes sense. Is the company protected by barriers to entry? Is there a first-mover advantage? How will changing laws impact them? On this last question, federal legalization could actually hurt some companies in my view.

I think that some of the companies have reasonably strong business models, while others have been unable to clearly explain what they are doing. Here are a few quick summaries of some of the companies that I think have done a good job of describing the business models:

  • Advanced Cannabis Solutions (OTCQB:CANN): Establish base business in Colorado as a landlord for growers and offer ancillary products and services
  • CannaVest (OTCQB:CANV): Production of cannabidiol ("CBD") from hemp that is sold in raw form or in finished products
  • GW Pharma : R&D focus on cannabinoids to treat significant diseases
  • mCig (OTCQB:MCIG): Low-priced vape pens that work with leaf, wax or even liquids (2nd generation product)
  • Medical Marijuana, Inc. (OTCPK:MJNA): Marketer of CBD-based products to consumers in all 50 states and around the world
  • GrowLife (OTC:PHOT): Equipment provider positioning itself to supply larger growers, with the ability to provide financing to its customers
  • Terra Tech (OTCQB:TRTC): Hydroponics herb and vegetable grower (and brand) with plans to grow hemp or marijuana when legally feasible

Management

Venture capital investors tend to discuss management as the most important criterion when deciding to make an investment. Given that almost all of the cannabis stocks are essentially start-ups, most with "going concern" statements in their disclosures and filings, investors should make sure that they are comfortable with the leaders of the company. Here are some parameters to consider:

  • Industry experience or expertise
  • History of success
  • Criminal background (sadly, this is an issue)
  • Independent directors
  • Accountability

Access to Capital

One of the challenges for companies trading on the OTC is attracting investment capital. Many of these companies have operating losses that need to be funded, and the choices are terrible, typically resulting in large issuances of stock at tremendous discounts to whatever the prevailing price might be in the future. This is compounded for companies in the cannabis space, who, for legal reasons, have struggled to gain access to bank loans or other providers of capital.

Here are two examples of companies that seem to be improving their access to capital:

  • CANN: In the middle of an underwritten convertible note that is underwritten by a Colorado-based investment bank and that has a conversion price of $5 (a fixed price and not a massive discount to wherever the future price might be)
  • PHOT: Entered into a JV with a private entity that allows them to fund $40mm or more of investments, including funding leases through its "GIFT" program

The bottom-line is that a start-up company needs investment capital to fund its business. If your cannabis stock isn't generating positive cash flow (and almost all are not), then having the ability to sell equity at a fair price or the ability to borrow is essential.

Transparency

One thing that has been apparent to me is that many investors do not take advantage of free information that will make them better able to decide the risks of investments in the sector. OTC Markets is a valuable resource for investors, providing links to disclosures for "pink sheet" companies and to filings for those that are SEC filers. When it comes to information, more is better, in my view. Pink sheet companies disclose a lot less than SEC filers. But, the fact that a company does file with the SEC is no protection. Reading the disclosures and filings is essential, and investors should also consider other communications, including press releases, Facebook postings, and CEO interviews. Here are some key things to look for:

  • Consistency (does the story keep changing, does the company deliver on its past promises)
  • Excessive promotion is cautionary as is total avoidance of shareholders
  • Alignment (how much stock do insiders own, are there conflicts of interest, is there excessive pay)

I have shared a lot on this point in my previous writings and will leave it to the reader to figure out which companies stand out as better or worse than their peers. The bottom-line here is that one should be especially careful with companies that don't file with the SEC, but that's not enough, as even SEC filers have some transparency challenges.

The Real Share-Count

OTC companies have a tendency to have strange capital structures compared to listed companies. Two things investors need to check are convertible debt and convertible preferred stock. These securities are described in disclosures and filings and can have a huge impact on the future share-count of the company.

The presence of these types of securities creates a "heads-I-win-tails-you-lose" scenario. If the company goes bust, any recoveries will go to the debt holders or preferred stock holders first (note that there likely won't be recoveries!). On the other hand, though, these securities can really dilute existing shareholders if the price rises. The issue is compounded by the fact that most data providers fail to properly account for these securities, so investors tend to underestimate the value of the companies. Let me share an example.

FusionPharm (OTC:FSPM) last filed its OTC disclosure for the June 2013 quarter. Right on the first page, it says that there are approximately 5.7mm shares outstanding (and it also states that there are approximately 1.47mm preferred shares). Yahoo Finance lists the shares outstanding as just 2.35mm, while Google Finance lists it as 5.7mm. OTC Markets lists the shares outstanding as approximately 8mm. If one reads the disclosure statement, the preferred stock converts to 147mm shares (100:1). It doesn't actually say that, but the table on page F-4 indicates that 20K were converted into 2mm shares. If one refers to the annual disclosure, it is spelled out clearly:

Right to Convert. Each share of Preferred Stock shall be convertible, at the option of the holder thereof, at any time. The conversion ratio is 100 to 1. In other words every one share of Preferred Stock converted will equal 100 shares of Common Stock.

So, while many investors who don't take the time to investigate the real share-count would believe, based on public sources of information, that the share-count is 5.7mm plus or minus a few million, the June filing indicates it is actually almost 153mm. This is a huge difference! At the peak last week of $2.95, FSPM was valued $450mm! Even today, at $1.26, the stock is valued at almost $200mm.

If a company were to buy FSPM, it would have to pay the owner of the preferred shares (the CEO, Scott Dittman, primarily), so the true value of the company must incorporate the preferred shares (which he has converted to common at a steady pace, by the way). This is important because some have speculated that PHOT, which has a distribution agreement with the company on the East Coast, could buy them. I would doubt that this can happen at even 15% of the current price.

This is just one example, and I have discussed others in the past. The bottom-line is that it is essential to figure out the "real" share-count.

Valuation

Valuation is especially challenging for penny stocks in my view. Given the favorable dynamics of strong demand for the cannabis stocks and limited supply of stocks, at least in the very near-term, I suspect that valuations will seem irrational at times during the balance of 2014. That's not to say that one should sit on the sidelines, as last week's huge move took really high prices much higher, but investors should be aware that the valuations are very optimistic. Greengro Technologies (OTCPK:GRNH) went from $0.04 to $1.20 ($300mm market cap based on conversion of preferred shares) at its peak on Wednesday before selling off to a closing price on Friday of $0.22. The catalyst was a Seeking Alpha article by a disclosed anonymous short that basically showed a picture of the headquarters. Keep this in mind when the market is frothy, as it doesn't take much to knock the wind out of the sails.

Conclusion

It should be clear that there are many aspects of the cannabis stocks that investors should consider before diving in. While my list of things to think about isn't necessarily complete, I hope that it helps readers to make a better decision if they choose to invest in the sector. For those looking for more information, you can refer here to a chronological listing of my contributions on the cannabis sector.

Source: Capitalizing On Cannabis: Key Considerations For Cannabis Stock Investors

Additional disclosure: The author has a paper portfolio at 420investor.com that is currently long MCIG